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Managing downside risk

This is an historical document which was correct at the time of publication. It is now out of date. It was most likely subject to different rules and regulators at the time it was in date.

As the asset management arm of one of the world’s largest insurers, Aviva Investors has a long track record of managing risk. Whilst this is an important task for all types of investor, it is critical for institutions such as insurers, and the managers of pension and sovereign wealth funds, which have both short and long-term liabilities that they need to protect against.

Unexpected and sometimes infrequent phenomena can wreak havoc on a portfolio as the global financial crisis of 2008 demonstrated. Yields on government bonds fell to historic lows as a result of that crisis, pushing many defined benefit pension plans into deficit.

To protect investors from events such as those of 2008, traditional funds tend to focus on buying products and strategies aimed at hedging so-called tail risks. However, as we shall explain, there are significant disadvantages to this approach.

Risk management is at the core of the Aviva Investors Multi-Strategy portfolios. We aim to shield investors and to deliver consistent outcomes, irrespective of market conditions. We do this by targeting strategies that can offset the potential losses borne by the rest of the portfolio as a result of any tail-risk events, as well as more standard market volatility.

The way that strategies are expected to interact with each other across a range of market conditions is crucial to managing overall risk exposures within the Aviva Investors Multi-Strategy portfolios. Our multi-strategy portfolios consist of three types of strategies: we call them ‘market’, ‘opportunistic’ and ‘risk-reducing’. The goal is to combine these strategies in such a way that we can deliver equity-like returns for less than half the volatility.

Each has a different role, and in combination helps us achieve our performance targets while managing risk. The first group looks to generate returns when markets perform as we expect, while the second aims to exploit opportunities where one asset appears mispriced relative to another. The last, and most important in terms of this article, aims to support performance when markets do not behave as we had anticipated. In other words, this group of strategies aims to lower risk.

When market conditions are volatile, these risk-reducing strategies can significantly boost portfolio returns at the same time as lowering risk. One of our investment ideas aims to protect investors from the slowdown in China, namely a position in Australian government bonds. The weakening Australian economy should lead interest rates to remain low and possibly fall further, boosting the appeal of government bonds. This strategy performed very well during the turbulence seen in August, largely sparked by concerns about China’s economic outlook.

We aim to shield investors and to deliver consistent outcomes, irrespective of market conditions.

Trevor Leydon

Head of Investment Risk and Portfolio Construction

A false sense of security

We think our approach is a better way of preparing for the unpredictable than hedging against ‘tail’ risks. For example, one method of tail risking hedging is to weight your portfolio to less volatile sectors. However, the increasing correlation between asset classes seen in recent years suggests that simply allocating investments across asset classes does not offer the same level of diversification as it did before the onset of the credit crisis in 2008. With bond yields so low and asset classes more correlated than in the past, an apparently well-diversified portfolio could in fact be carrying significant risk.

In addition, while investors may think they have a diversified portfolio because they hold a mix of assets, they may be taking more risk than they appreciate. For instance, a portfolio that holds 60 per cent of its assets in equities and 40 per cent in bonds, is actually placing 90 per cent of its risk in equities due to the relatively risky nature of that asset class.

Money well spent?

Cost is another considerable disadvantage to tail-risk hedging. Buying sufficient protection on multi-million or multi-billion pound institutional portfolios involves a very large cost, which we believe will generally outweigh the benefits. The cost of implementing widely-used hedging strategies, such as buying put options and ‘volatility’, can be prohibitive if they are bought in sufficient quantities to protect against the most extreme events.

Moreover, hedging against events that may never happen represents a continuous drain on the portfolio. Consider, for example, a strategy that involves buying put options, which confer the right to sell an underlying asset. Their value will soar if the underlying asset’s price plunges. However, if it does not, they will expire worthless and the investor will have to buy new options to replace the old ones. By contrast, in the Aviva Investors Multi-Strategy portfolio we look for investment ideas that do not cost anything or, at worst, involve a small negative cost. In other words, they do not act as a continuous drag on performance but do provide a permanent shield.

Despite the heavy cost of hedging strategies, the events of 2008 also called into question their effectiveness. Investors who bought credit default swaps (CDS) to protect against losses on their corporate bond holdings and therefore thought they had hedged their credit risk, appeared not to be adequately covered following the collapse of Lehman Brothers and AIG (who were both heavily involved in selling CDS).

Trying to time the market is a hazardous occupation

Investors often seek to reduce the cost of hedging by trying to buy insurance only when they believe their portfolio is most at risk. Investors use the numerous indices that try to plot different characteristics of market stress in order to help them anticipate sell offs. However, volatility can spike and recede very quickly - by definition, it is impossible to anticipate unexpected events!

Another problem with traditional hedging is that it requires the recruitment of talented specialists, who can clearly articulate these strategies to the broader stakeholders so that the latter can implement and monitor them. These specialists are highly paid and may be reluctant to move from institutions that have already devoted significant resources to developing an expertise in this area. One could also question whether they would thrive in pension and insurance companies, many having developed their skills in the less structured culture and quicker-moving world of hedge funds and investment banks.

Another drawback associated with traditional hedging is that it tends to focus on Value at Risk, or VaR. Using observations of historical market movements, VaR is a means of measuring how much an investor could expect to lose should a ‘normal’ risk event occur. VaR tends to be a function of volatility and the greater the turbulence, the more an investor may lose.

However, relying on VaR has drawbacks. Prior to the gyrations seen towards the end of August 2015, for example, a model looking back over the previous five years would have indicated that the environment was benign and there was little risk. When volatility picks up, VaR models tend to react only slowly and they thus have less predictive power than might be expected.

The calm before the storm

Any investor who focused solely on a VaR model in the run up to the 2008 global financial crisis would have received little warning about what was going to happen. The unruffled financial waters would not have indicated any need to run stress tests. However, if an investor had adopted a robust regime involving stress tests, looking at hypothetical and historical scenarios, and run VaR models with varying degrees of confidence intervals, holding and look-back periods, they would have received signals that would have left them much better able to navigate the crisis

Thus, at Aviva Investors, we half-jokingly refer to “the wrestling ring of risk”. This refers to the importance of having a wide range of tools at your disposal to help predict risk. The idea is that the more ropes you have surrounding the ring, the more secure you are against being thrown outside.

In conclusion, it is clear that even the best economists or investors cannot claim to predict the future correctly. This is the premise upon which our Aviva Investors Multi-Strategy portfolios have been built. We seek to shield the portfolio from unexpected events by implementing a wide range of strategies that can offset periods when markets behave in an unexpected manner. It is an approach which we are convinced is far more cost effective and efficient than traditional forms of hedging.

Managing portfolio risk in the AIMS portfolios

We believe integrating risk and portfolio management from the very outset is critical. Our multi-strategy portfolios invest in a wide range of strategies and our portfolio managers are free to invest in a broad range of assets and regions. When implementing these strategies, the managers assess their impact on the overall portfolio’s risk.

The portfolio’s risk analysis team plays a vital role in helping the portfolio managers construct portfolios as risk considerations are at the heart of the process. The team works closely with the portfolio managers, rigorously testing individual strategies. All strategies pass through a stringent pre‐trade risk process before being incorporated into the portfolio. Strategies are assessed according to their expected risk and return, the ease with which they can be exited, and whether they will work if the portfolio grows substantially in size. And the team also tests how the overall portfolio would perform in different market conditions.

Monitoring risk

The risk analysis team continuously monitors risks both in terms of individual strategies and the overall portfolio. The team conducts regular stress tests on the portfolio and assesses optimal trade sizes. It analyses risk from the level of individual instruments and securities through to asset classes and ultimately the total portfolio level. In addition, an independent team monitors market risk separately.

Managing derivatives risk

As our portfolio managers invest significantly in derivatives contracts, we place particular emphasis on monitoring the potential impact of those being used. Using derivatives can result in a higher level of risk compared to investing directly in more traditional assets. However, our investment team and risk specialists are very experienced in managing derivatives risks. We believe their experience and careful risk control mean that the level of derivatives risk introduced into the portfolio will remain consistent with the portfolio’s risk profile.

Important information

Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (“Aviva Investors”) as at 31 October 2015. Unless stated otherwise any views and opinions expressed are those of the author. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.

Issued by Aviva Investors Global Services Limited, registered in England No. 1151805. Registered Office: St. Helen’s, 1 Undershaft, London EC3P 3DQ. Authorised and regulated by the Financial Conduct Authority and a member of the Investment Association. Contact us at Aviva Investors Global Services Limited, St. Helen’s, 1 Undershaft, London EC3P 3DQ. Telephone Calls may be recorded for monitoring and training purposes.